Why America should care about Europe’s economy

Traders are pictured at their desks at the Frankfurt stock exchange on July 13.

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As European economic woes worsen, should Americans worry about the eurozone? After all, the US has plenty of its own economic troubles to contend with.

But in this globally connected world, there's plenty of concern to go around. American jobs and economic growth are directly tied to how and when Europe addresses its fiscal and debt problems, as well as to Chinese inflation and exports. In turn, China depends on the US and European ability to return to robust growth. And the entire global economy rides on Congress approving higher US debt levels.

In short, economic fumbles in Europe will be felt in America, and vice versa. After a couple of years of mostly uncoordinated global recovery strategies and trillions of dollars in bailouts and stimulus funds that have had mixed results, weakened world economies have less room to maneuver and are thus more exposed to what happens elsewhere.

“Even if it looks far away, there is no way for the US to be immune to significant issues in Europe,” says Gilles Moec, a London-based Deutsche Bank senior economist. “We’re talking about a really large amount of national debts which are at risk which could bend global wealth.”

One may ask how the probable default of a tiny economy like the Greek one can wreak more havoc in world markets than Argentina’s 2002 default. The difference is that markets are on edge, increasingly irrational, and reacting more to speculative scenarios than to real numbers. That’s the nature of the beast.

The EU has dragged its feet on how it will deal with the unavoidable Greek default and second bailout, which in turn raises the question of how it would address an increasingly likely new rescue of Ireland and Portugal. And if there is no clarity on what happens with the small, more manageable peripheral countries, then it’s all together uncertain what would happen if Spain or Italy needs funds eventually.

It’s not a question of solvency per se, that is, about European countries being able to pay back their debts, but of liquidity. Market concern is that Europe will not be able to agree on a timely strategy to make sure all the contingencies are in place. And if there is no liquidity, then the solvency issue becomes real, not psychological.

Many investors can’t take that chance and thus are rebalancing their exposure just in case, moving their money to safer assets, which explains why markets plummeted globally in the past few days.

“It’s quite hard to disentangle anymore. In general it’s risk aversion,” says Luigi Speranza, a London-based economist with BNP Paribas. And even if there is little new evidence to justify a run on Italy or Spain, “the market is on high alert. And you can’t underestimate market reaction because it can be self-fulfilling."

Rating downgrades abound

That is why rating agencies this month downgraded the Portuguese and Irish debt to junk status and warned that Spain, Italy, and perhaps Belgium and France could soon follow. The driving concern for now is not economic, but political. The same could be said of the US. But political will lacking, the problem becomes economic.

Even if policymakers eventually react, as expected, a more robust recovery will be delayed. The so-called soft patch that the US is enduring, will be longer and more uncertain. Developed economies will thus consume less internally and exports will fall. Developing economies, in turn, will take a toll because they will export fewer raw materials, whether its oil or copper. And together that could weaken the export-driven motors in China and Germany.

Europe’s economic woes could also lead to billions in losses for US investors exposed to European markets, particularly Italy’s, which again undermines the US economy. And this is under an optimistic scenario that policymakers across the globe will eventually sooth markets with a stronger reaction.

“The market used Spain and Italy as an alternative to smaller peripheral countries. But it’s lost trust now. There’s a panic coming in. It clearly shows that markets got nervous about the ability and willingness of Europe to deal with crisis,” says Juergen Michels, a London-based euro zone economist with Citigroup.

That sent the cost of borrowing of Spain and Italy to record highs since they entered the eurozone, which have since subsided thanks to assurances from both governments. European foot-dragging, however, risks a sustained climb of sovereign debt interests. In that case, both countries with huge economies would not be able to turn to capital markets for money, and the EU would have to step in.

“The money is not there,” says Mr. Michels, referring to the EU’s and international Monetary Fund bailout money. The amount of money available would need to be at least doubled, perhaps tripled to 2 trillion euros “and that puts Germany and France in a very difficult position.”

Double dip?

Investors are also increasingly anxious a perfect storm is brewing that could trigger a double-dip recession that would make the recent downturn look mild. That would involve a worst-case scenario in which Europe’s debt crisis spreads to big countries, the US debt ceiling is not raised, and China’s economy is unable to drive global growth.

No need to panic though. Cautious markets are just anticipating a scenario that few analysts believe is forthcoming. The debt ceiling will likely be raised, Europe will eventually act decisively to stop contagion because not doing so is exponentially more costly, and most believe China will manage to keep a healthy balance between growth and inflation.

But then again, politics is not rational. Uncertainty is growing and wiggle room is disappearing. So stay tuned because trouble at home is no longer determined by Washington and Wall Street, but on how the rest of the world deals with this panic.